Regional trade agreements have spread rapidly throughout the world since the early 1990s. This column surveys the latest theoretical and empirical research on regionalism, asking whether we should celebrate or be concerned about this trend. It concludes that although countries should approach regionalism with care, such agreements have been more of a blessing than a burden.

The lack of progress in multilateral trade negotiations does not imply that global integration is stagnant. In fact, governments across the globe are as active as ever in negotiating new regional trade agreements (RTAs). For example, in the year to October 2009, as the global financial crisis raged, 25 new RTAs were notified to the WTO. The new agreements bring the total number of RTAs in force to nearly 300. This has led many economists to worry that regionalism could be undermining the multilateral trading system (Bhagwati 2008, Limao 2006).

In recent research (Freund and Ornelas 2010), we ask whether the expansion of regionalism should be celebrated or a cause for concern.

Assessing the impact of RTAs

Regional trade agreements imply both trade liberalisation and trade discrimination. While there is a near-consensus among economists that trade liberalisation is desirable, the same cannot be said of trade discrimination. Such discriminatory trade liberalisation is beneficial when it promotes a shift of resources from inefficient domestic suppliers to more efficient producers within the region, i.e. when there is so-called “trade creation”. In contrast, a trading bloc is likely to be harmful if it generates a shift of resources from efficient external producers to inefficient producers within the region, i.e. when there is so-called “trade diversion”.

There are theoretical arguments that support the primacy of trade creation and trade diversion under similar circumstances. Thus, which effect dominates is an empirical matter. Unfortunately, estimating trade creation and trade diversion is no easy task – it requires knowledge of the counterfactual, i.e. what would have happened to trade if there were no trade agreement. As this is unknown, assumptions must be made.

A variety of approaches have been employed. While results inevitably vary depending on the methodology, the time period, the trading bloc in question and the level of aggregation in the data, two general messages arise from the large set of studies investigating trade creation and trade diversion in RTAs around the world:

First, trade creation tends to be the norm in RTAs – and trade diversion is the exception.

Second, when trade diversion is observed, its magnitude is normally relatively small.

Trade creation vs. trade diversion

Why is there such a dominance of trade creation? It seems that governments are choosing their partners well. For example, variables that suggest greater gains from a bilateral deal (such as proximity between the members, a similarity in their GDPs and a large difference in their factor endowments) are also sharp predictors of whether the two countries actually have a common RTA (see for example Baier and Bergstrand 2004).

Moreover, when countries form an RTA, their governments not only lower tariffs vis-à-vis their RTA partners; they also tend to reduce tariffs on imports from countries outside the bloc. Governments liberalise externally because they choose to – there is no reciprocity from the non-members. Such external trade liberalisation following an RTA appears especially important in developing countries (Estevadeordal et al. 2008 analyse Latin America in the 1990s). The lower external tariffs provide a double blessing. They imply that RTAs are responsible for more trade liberalisation than they mandate – amplifying trade creation – and for less trade discrimination than might be expected – limiting trade diversion.

Why voluntarily lower tariffs?

Given the political pressures, it may seem counterintuitive that governments would voluntarily lower their external tariffs. But it makes sense. Suppose for political reasons the government sets relatively high tariffs, which benefit the domestic import-competing industry. If subsequently the country enters in an RTA, export-oriented firms benefit because of the better access to foreign markets, whereas purely domestic firms suffer from the tougher competition from the RTA partners. This weakens the import-competing firms’ stance on protection against non-members. The reason is that the free access to the domestic market enjoyed by the partners’ exporters lowers the market share of the domestic industry. As a result, the RTA makes any price increase generated by a higher external tariff less valuable for the domestic industry. Now whenever the government attempts to help domestic producers through higher external tariffs, the partners’ producers absorb part of that surplus.

In other words, the RTA creates “leakage” in the trade-policy redistributive channel. External protection also becomes more costly, because of the costly trade diversion that accompanies the RTA. As a result, external tariffs tend to fall after the formation of an RTA, both because the economic marginal cost of external protection rises and because the political-economy marginal gain from external protection falls.

Empirical research supports this rationale for developing countries. But results for the US and the EU indicate that they are less likely to reduce external tariffs on goods where preferences are offered (Limao 2006). But since the tariffs of both the US and the EU are very low to start with, and cannot be raised because of their WTO commitments, there is little room for change anyway.

Are regional trade agreements welcome?

The benign view that trade creation dominates trade diversion does not imply that regional trade agreements are necessarily welcome. Some commentators argue that the reason multilateral negotiations at the WTO are stuck is because RTAs are spreading. One concern is that if officials are busy negotiating bilateral agreements, they will be unable to focus on more evolving multilateral negotiations. Another concern is that RTAs may create interest groups that block further liberalisation initiatives.

There are also arguments indicating that the opposite may be true. A simple argument is that negotiating RTAs helps officials develop the expertise to implement international trade agreements, which could be useful at subsequent WTO negotiations. Moreover, RTAs also destroy rents in parts of the economy. If the rent-holders who lose with RTAs were the ones slowing down multilateral talks, then RTAs can actually provide a boost to multilateral negotiations. As Baldwin (1994) puts it, liberalisation (regional or multilateral) begets more liberalisation.

When faced with opposing theoretical results, the solution is typically to scrutinise the divergent predictions empirically. The problem here is that the nature of the question – whether regionalism helps or hinders multilateralism – does not lend itself easily to testing. Simply put, at any point in time we observe a single realisation of WTO negotiations. Would they have been any faster, or easier, had there been fewer (or more) RTAs? This is a very difficult question. As a result, to date empirical scrutiny has not been able to help us distinguish good (that is, empirically relevant) from bad (empirically inconsequential) theories.

Conclusion

To the extent that we can measure it, the increasing wave of regionalism has been largely beneficial to the world trading system. Most empirical analyses indicate that trade creation, not trade diversion, is the norm, both because governments choose well when forming RTAs and because they adjust other trade policies to moderate the distortions from discrimination.

Although it is possible that regionalism could endanger multilateralism, at the moment we just do not know. Since regionalism has become, and will probably remain, the preferred form of reciprocal liberalisation for most countries – no matter what we economists say – we should therefore focus on ways to integrate regionalism with multilateralism more effectively.